Revisiting The Old Rules Of Investing

DON'T:

1. Pay attention to hot tips. They rarely pan out. If a tipster has access to true inside information, it is illegal for you to profit from it, so your best course is to walk away. Bernard Baruch, one of the most successful investors and a Wall Street legend, once remarked, "When shoeshine boys start handing out stock tips, it's time to sell!" That's still true!

2. Accept everything you're told. Be skeptical of salesmen selling investments or schemes. The best investments sell themselves and don't need people touting them, especially strangers. After all, if an investment were truly attractive, why wouldn't the salesman put in his own money instead of trying to persuade others to do so? The reason has to be he's getting paid more from selling the investment than by the potential return of the investment itself. Either that or the salesman has no net worth. In either case, it warrants ignoring.

3. Believe in the infallible company. Polaroid was infallible 30 years ago, but now it's bankrupt because it couldn't keep pace with new technology. AT&T was the unsinkable Titanic of Wall Street inside its impenetrable steel-plate hull of government-mandated monopoly. When deregulation cracked that monopoly, its competitors closed in like sharks to the scent of blood.

4. Extrapolate current trends far into the future. My business is located in Aspen, so I see all too often the common assumption that since Aspen real estate has averaged a 15% return over the last 20 years, it will continue to do so. It can't! Aspen real estate is now so expensive that a 4,000-square-foot home fetches $4 million. If you were to assume the 15% average rate would continue for the next 40 years, the same house would sell for $1 billion — improbable, to say the least.

5. Use your cost as a reference for an exit point. The market doesn't care where you bought your stock. One of the most common mistakes investors make is to say, "I bought ABC stock at 65, but it's dropped so much I'm going to wait for it to go back to 65 before I sell it." The problem? That stock may go to zero first. Evaluate the influences upon and the value of your investment and establish a rule for cutting your losses.

6. Confuse luck with skill. A lot of investors thought they were smart when it came to the stock market during the 1990s. The more they attributed their wealth to their own skill, the more confident they became and either became overweighted in stocks or took increasing risks, with disastrous results when the bubble burst. Do not make that mistake. Warren Buffett said it better than most: "It is optimism that is the enemy of the rational buyer." Choose your investments carefully!

7. Follow the herd. This may work for picking a restaurant or a movie, but not for investments. In 1999, Lucent became the most widely held stock with 4.7 million shareholders, and it traded above $45 for the entire year. Including its spinoffs, Lucent now trades at $2.15 (as of March 2003). Enough said.

8. Put yourself under undue financial pressure if the market doesn't move in the direction you want it to. Overextending yourself, either through margin or by overweighting stocks in a bear market, could be one of the costliest mistakes you make. This could force you into a position where you must sell out at disadvantageous prices, in turn causing you to postpone or cancel your retirement, or worse, forcing you to downgrade your housing and lifestyle. All this can be avoided by approaching investments knowing that every investment can lose 100% of its value.

DO:

1. Know when to act and when not to act. Sometimes, doing nothing is the best course. It's human nature to sell when stocks are going down and to buy when they're going up, the goal being to try to avoid losses or, conversely, get in on the gains that everybody else is enjoying. However, if investors who owned stocks had done nothing at the height of the market in September 1987 (right before a 32% slide), they would have been better off 22 months later. If investors who were all in cash had avoided buying into the frenzy of 1999, even at the low point of the period (January 1, 1999, through March 31, 2000, the peak of the frenzy), they would have been 14% better off than today (66% if they invested in the Nasdaq). Sometimes, your no-trade decision is your best decision.

2. Separate the quality of the issuer from the quality of the stock. This is not an easy thing for an amateur investor. Many investors make the mistake of thinking, "Wow, that company is really doing great" or believing that some glowing report from the financial press is a good reason to invest in a company's stock. The stock price is usually way ahead of itself by the time this kind of news is released, because with public stocks, it's no secret how well a company is doing or even how well it should do in a given climate. When GE was clicking on all cylinders in mid-2000 and business couldn't have been better, that was the highest point of the stock and the time to sell.

3. Know when to rebalance. Who said that buy and hold is a great strategy? The reality is that it rarely works, especially if you run your own stock portfolio. For example, if you bought Avon Products in 1970 at $22 per share (a great company and a member of the Nifty Fifty), you would have waited until 1996 to show a profit and would have been more than three times better off having been in Treasury bills the entire time through today. Academic research supports the buy-and-hold approach over long stretches of time, like 20 years or more. Theoretically, you would do well if you waited out market droughts like the one stretching from the late 1960s to the start of the bull market in 1982. However, few people behave like a mathematical model, because risk tolerances and personal finances change significantly through time.

4. Have a plan for your investments and a way to measure progress — time horizons, exit points, revenue growth, and so forth. For example, if the chairman of a company claims he thinks the company will ship one million units in the upcoming year and the company ships 400,000, then the quality of management is questionable and you may want to reevaluate your investment.

5. View your investments as "stored labor" and calculate how many hours they represent. This encourages prudent risk-taking. For example, if you have $1 million to invest and you net approximately $50 an hour in your profession, your portfolio represents 20,000 hours of labor, or about 10 years. Hence, if you lose 20% of your portfolio, you'll have to work almost three years to get even (accounting for taxes and risk-free interest foregone). If you're retired, you may not be able to get it back at all without further risk-taking. Do not get in this position.

6. Hire a competent advisor and do not listen to inexperienced or uneducated sources, especially those with an agenda. You want advisors who are inherently conservative, have an in-depth understanding of the market, and are independent in their thinking. A healthy sense of skepticism is an important element in judging investments successfully. How do you judge advisors? Look at their background, education, professional achievements, and referring sources.

WHAT IT ALL COMES DOWN TO

Investing doesn't have to be a gamble. By honoring the old rules of investing and learning from the collapse of the New Economy, you can maintain or even improve your position in an extended bear market. And when the next version of the New Economy pops up in the inevitable clown costume of hot tips and media buzz, you can leave the frenzy to the fools.

Wally Obermeyer is the president of Obermeyer Asset Management located in Aspen, CO.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.